Yves here. Even the China bulls are coming to see the financial system as a risk factor.

By David Llewellyn-Smith, the founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut. Cross posted from MacroBusiness

The AFR finally has some realism coming out of the spate of mining conferences underway in Hong Kong:

While the view on China is overwhelmingly positive on the main floor of the Credit Suisse Asian Investment conference, where executives are talking about continued strong demand for steel and a fast-growing economy, a darker picture has emerged in the private rooms and closed sessions such as the one titled Asian banks: banking crisis – who’s next, India or China.

For China, the fear is that all the preconditions are in place for a banking crisis, including an explosion in credit at the same time the economy is slowing.

“I think there is a 60 to 70 per cent chance that the Chinese government will need to bail out the banks in three years,” said one participant. He warned that the knock-on effects for growth and commodity prices would be severe.

“If China can’t maintain the pace of fixed asset investment, then growth falls below 5 per cent or even to zero,” he said. “The market is not mentally prepared for that.”

Hear, hear. As it happens, yesterday UBS also clarified a recent note on its concerns about Chinese shadow banking:

The concerns we raised over growing shadow banking in China in a recent note got overwhelming support, but some were critical, saying most of China’s shadow banking is regulated, and that its size is still very small compared with that in developed markets and China’s own formal banking system. We were never in the ‘hard landing’ or ‘imminent financial crisis’ camp, but there are factors investors or policy makers should not ignore.

In fact, we agree that (i) most of China’s shadow banking is regulated – since much of it is off-balance sheet credit activities of (regulated) banks and trust companies that are regulated by the same CBRC; and (ii) the size of shadow banking is still small – about 40% of GDP compared to 100% of GDP in some developed markets. However, being regulated is not same as being well regulated.

Most people would agree that the off-balance sheet activities of regulated banks are not as well regulated as regular bank lending, and trust companies and other non-bank institutions are not under the same kind of scrutiny as banks. Also, while the size of shadow banking is still relatively modest, which should reduce systematic consequences of any problem, the very rapid growth, coupled with less-strict regulation, are causes of concern.

Again, we are not saying that China is facing a financial crisis. It is our long-held view that despite some structural issues and some non-performing loan problems, China’s banking system does not have systematic risk in the near term. However, to say that China’s financial system is not about to collapse does not mean that there is little risk to concern investors or that policy makers should ignore some of the clearly unhealthy and unsustainable developments.

…In the near term, we see macro risk and liquidity risk as the two biggest risks arising from the rapid shadow banking credit expansion.

On the macro side, the rapid growth in shadow banking credit has led to a significant easing of overall credit conditions since mid 2012. While this has been helpful for growth recovery, people including policy makers who have focused on the traditional broad money and bank lending indicators may misjudge the true credit conditions in the economy. In such a case, policy adjustment may be delayed until massive leverage increase has led to over-investment, inflation, and/or asset bubbles. By then, the government may have to tighten credit abruptly, causing more pain to the economy and leaving NPLs in the wake.

Another major risk is economic volatility related to unexpected liquidity tightening. Liquidity in the shadow banking sector is generally not very stable compared with deposit-funded regular bank lending, and depends heavily on market confidence. Payment issues in parts of the market (for example, wealth management products or local government platforms) could shake confidence and dry up liquidity suddenly. Alternatively, the government may decide to clamp down on some specific WMPs or irregular local government financing practice, leading to a quick shrinkage of some shadow banking activities. In these cases, the most likely scenario is that banks either bring the underlying assets back to their balance sheets (along with deposits), or develop other products to take things over. However, either takes time and banks’ balance sheet can not expand quickly enough to completely compensate for the drop in shadow banking, especially as banks face credit quota and other regulatory constraints. In both cases, a liquidity and credit tightening occurs, perhaps even unintended by the government, in which case it may loosen later, but the damage would have been done, leading to volatility in the economy. This is kind of what happened in the summer and Q3 of 2011.

In the near term, these two risks are our main worries about China’s rapid shadow banking development. Of course, if such rapid development is left unchecked for a long time, we will also worry about systematic risks. At the moment, not facing a big systematic issue is not a reason to ignore the development in shadow banking or overall credit conditions, especially for gauging cyclical developments and policy directions.

What might happen next? We believe that while the authorities have generally been supportive of the shadow banking development, they have expressed some concerns on the lack of transparency in some wealth management products, and in excessive debt accumulation of some local government platforms. Even if the government does not tighten or change monetary policy direction soon, the speed of credit expansion is likely to slow, at the latest in H2, and activity growth will slow as well.

In short, the price of reform is now cheaper than the risks of letting the model run.

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16 comments

Chinese proverb: The candle that burns twice as bright burns half as long.

Considering China’s meteoric economic boom, this can’t go on forever. And with all that rapid growth there must have been some shortcuts made that, once a slowdown happens, will unravel the whole thing. A bit like our very own ‘subprime’ mortgages.

If China does slip into a crises, what will be the implications as far as China’s gold holdings? It’s been widely reported that China has been accumulating the precious metal over the past couple of years, in fact it imported nearly 1000 tons from Hong Kong in 2012.

I kind of smiled wryly when I read this article. In broad stokes it presents the general idea that China has a regulated financial market and a generally unregulated shadow financial market. This, on the face of it is true.

However, China’s shadow finance industry is not, by western definition, a shadow finance industry that challenges the established, regulated markets in the “usual” way – it doesn’t have the sophisticated financial instruments, synthetic CDO or CDS’s or the ability to stealthily expand the money supply. It’s all ‘mom & pop’.

Why? Because the China shadow banking financial market exits of what is called, locally, “small-sum loan companies”, pawn shops and loan “Guarantee” companies – not the hot financial foundries of a Bear Stern or a Lehman Brothers forging synthetic credit into multi-trillion, multinational line of toxic dominoes that threaten to topple western economies as soon a country defaults.

The numbers are fascinating: The number of small-sum loan companies and related entities across China is 4000 with an aggregate loan balance of 392 billion Yuan; 5000 pawn shops nationwide with total assets of 118 billion Yuan and 6,000 “Guarantee” companies with total paid-in capital of 450 billion Yuan. As such, the real financial challenge to the regulated market is interest rates. It’s been the continuous rise in “private” interest rates has reduced deposits at banks. Basically, your Beijing, Shenzhen and Shanghai punter has been “loaning out” his/her savings.

The Chinese main-lander is, if anything, stereotyped as great mom-and-pop saver but also a great mom-and-pop gambler; and it has been a large percentage of funding from these mom-and-pop locals, that has flowed, via the shadow banks, to the real estate industry (which, presently, is subject to austere funding controls). In effect the loans were/are real estate gambles.

The total amount of “new” funding to real estate trusts from shadow banking in 2011/12 was estimated at 380 billion Yuan – Shanghai and Shenzhen recorded over 200 “loans by mandate”, with cumulative lines of credit exceeding 20 billion Yuan at, incredibly, annual interest rates of between 12 and 24 percent (and, it’s not just real estate paying those rates).

Why are these interest rates so high? Well, beginning in 2011, commercial banks were required to work out a specific plan to transfer the off-balance sheet assets of bank and Trust Company Cooperation business to the balance sheet at a rate of no less than 25 percent per quarter; and by early July 2011, the CBRC told banks to cease offering “six categories of financial products” which included their most profitable, high-yield products such as ‘loans by mandate’ and ‘financing notes’. Combined with other macro-economic factors, interest rates declined, and investment opportunities were reduced. Consequently, the People’s Bank of China reported RMB deposits decreased by 10 trillion Yuan in 2012. Loan volume decreased over the same period by 2.0 trillion Yuan – the money was looking for higher returns.

It’s been this type of shadow banking that has, to-date, significantly increased the volume of capital flows, weakened the effects of macro-level controls and, to a great extent, usurped the CBRC efforts in managing macro-level policy, operational and systemic risks, supervision and regulation. The demand for shadow bank loans is there, but alongside this demand, is the CBRC’s effort to rein it in by promoting a ‘proper’ market-based interest rate environment and establish a multi-tiered loan market, so it should stabilize….. Anytime soon.

About these Chinese mom and pop purveyors of high-interest-rate creditors, here Claudius says: “(they are not) the hot financial foundries of a Bear Stearns or Lehman Brothers forging synthetic credit into multi-trillion, multinational lines of toxic dominoes that threaten to topple western economies as soon as a country defaults.” Or if it doesn’t default, it is brought to its knees and millions are impoverished. Beautiful and ironic that this is such a good description of blacksmithing and Hephaestus. The forger of both money and arms.

I respect your sense of smell. However, in this case I doubt it pyramidal. Almost every retail establishment of note in China requires a license; this includes Pawn Shops, small-loan shops and ‘Guarantee” shops; so we have a good idea as to the number out there. We also know that there is not one entity that owns a majority (actually any more than three for ‘independents’) of such shops – indeed, it’s perceive as usury which is a punishable offense and, in some regions, it’s a capital offense (an inheritance from Mao’s time, when it was banned altogether. I believe up until 1987). The “respectable” (less than 60) shops team-up (launder) with provincial banks – which take a cut of the loan rate.

It’s a little late for me to complete a detailed breakdown for you, so I’ll simply give you a baseline of from a Bloomberg report from 2009 (it was the first in the Google search list, but it suffices):

Bloomberg reported: ‘In 1997, Beijing only had four pawn shops. This year, Beijing and Shanghai authorized a record 94 new outlets for 2009 in an effort to channel funds to the entrepreneurs who drove the nation’s biggest economic boom, according to the Beijing Pawn Trade Association and Shanghai Pawn Trade Association. “Pawn shops are filling in the financing gap by lending to small and medium-sized companies and there is still room to expand that function,” said Yi Xianrong, a researcher with the Institute of Finance and Banking under the Chinese Academy of Social Sciences in Beijing. Pawnbrokers have become so important for entrepreneurs that Bank of Communications Ltd., China’s fifth-largest bank by assets, has teamed up with Beijing Huaxia Pawnshop Co. to target small and medium-sized businesses. Under their joint project, “Bank-Pawn-Expressway,” a borrower can get a quick loan from Huaxia to meet urgent funding needs and then repay the pawn shop once it gets a cheaper bank loan, which the pawn shop guarantees.’

As for my comment that China’s approach to the ‘problem’ will “stabilize any time soon”, was my poor attempt at wry sarcasm.

Well, probably, it is over leveraged somewhat – those high real estate interest loan rates have to realize somehow. But not as leveraged as one might think (it’s the shadow interest rate mechanism….). There are no loan insurance products for pawn shops loans. No credit default swaps…. And, on the real state side, it’s really a giant casino; the loss on a bad real estate gamble goes to the house. So, the open question is how this affects the real economy? The money doesn’t leave the state or even the country; it’s just put back into the real/shadow economy.

Still, the real problem relating to the leverage issue is that the CBRC sets a single Interest rate, that doesn’t adequately reflect the market’s loan dynamics. And, frankly, the shadow market has done what the State controlled banks have not – used innovation and a diversified risk platform and, by doing so, efficiently expanded financial services to China’s great unwashed. – something that commercial banks have, until recently, been unable to support due to cost, compliance or risk assessment and mitigation; all of which cuts into very marginal profits of a fixed interest rate.

So, through 2012, CBRC has ‘fast-tracked’ the reform of state-owned banks and moved to a market-based interest rate environment. The early phase resulting in: optimization of capital allocation (using regional rather than central models), breaking profit monopolies (better license allocation and distribution of the most profitable financial products), improving risk monitoring and control systems (again, regionally based rather than central) and (remarkable for its late development) establishing a financial institution withdrawal mechanism, the lifting of controls on deposit and loan interest rates and, most effectively, allowing muti-tired interest rates to move with the markets (plural).

Banking aside, China is looking at a raw materials crisis in the next decade. At a ~7% growth rate, their economy will double in size in the next decade – theoretically.

The problem is that they presently use half the world’s cement and 30-45% of the world’s production of iron, lead, tin, copper, nickel, and other minerals. Also consider their increase in energy use compared to incremental increases in production and geometric increases in investment/production ratios. I can’t see them trying to double their consumption of these commodities without triggering growth-killing commodity inflation.

Either they have to quickly engineer a dramatically resource efficient growth plan or they are going to bang up against production constraints. Since their economic growth is mostly based on physical exports, I don’t see how that could happen.

The political side of it is that the Chinese government cut a tacit deal with the masses back in 1989. Give up democracy efforts and we’ll give you prosperity. The government has held up its half so far, but it can’t go on.

Consider Steve Kopits’ observation that 4 out of the 5 most recent recessions in the US have come after oil costs exceeded 4% of GDP. China is facing a triple threat – minerals, energy, and banking.